March 17, 2022

What Happens When the Fed Raises Rates?

By Michael McKeown, CFA, CPA - Chief Investment Officer

What Happens When the Fed Raises Rates?

The Federal Open Market Committee raised interest rates for the first time this cycle. This signals a further change in the stance from the accommodative policy in place since March 2020.

The goal is to slow inflation by increasing the cost of debt. In turn, this lowers demand. The balancing act is trying to do this while maintaining economic growth.

The cost of debt will increase for businesses and consumers using floating rate loans and future fixed rate loans. On the plus side, we will see rising interest rates for savings accounts, CDs, and short-term bonds.

When interest rates rise, bond prices fall. The repricing of bonds in this cycle has been harsher than in the past give the speed and magnitude of expected hikes. Just a year ago, markets were pricing several more years of accommodative policy.

The following table shows the duration and magnitude of each time in the last 45 years the Federal Reserve raised rates more than five times. This time, the market odds implies ten interest rate hikes, with seven hikes by the end of 2022.

Interest Rate Hiking Cycles

Some would think it is a terrible time to own bonds during these periods. Historically, this was wrong. Bond prices produced positive returns on a five-year view from the first rate hike using the most widely followed bond index.

Bloomberg U.S. Aggregate Bond Index

In fact, only 1994 saw returns that were not positive one year after the first hike. The index total return was -1% after the first hike in February 1994. This initial rate hike was a total surprise hike by then Fed Chairman Greenspan. Since then, Federal Reserve members communicate to markets and the public their outlook for interest rates all of the time to avoid surprise. In fact, the communication is considered part of the policy as they understand all of the Fed speeches and press conferences have an impact on interest rates.

The high inflation of the late 1970s did see a rough ride for bond returns, though the results annualized at over double digits once inflation was tamed.

This gets to the bear case today. Supply side issues are causing inflation to be above the Fed’s target and affecting consumers negatively.

This in turn is causing durable goods prices to rise far above the levels of the past three decades.

Annual PCE Inflation

In a pandemic world of lockdowns and massive fiscal stimulus, consumers shifted spending to goods from services. Will this continue to last? The spending shifts along with the extent of further stimulus will be key factors on inflation and rates in the years ahead.

If past is prologue, it pays to be patient with bond portfolios despite the Fed raising interest rates. We will continue to monitor the inflation outlook to see if changes in spending, interest rate hikes, and policy measures begin to change inflation’s trajectory.

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